“Six months ago we were suffering a financial sector crisis. Now it’s an economic crisis of monumental proportions.”
So says Gary Potter, co-head of Thames River Capital’s long-only multi-manager business.
Likewise, Jonathan Barber, lead manager on the Threadneedle UK Monthly Income fund, says: “The economy has gone off a cliff.”
Indeed, in the past three months we have gone from bad to worse as the breadth and depth of the financial crisis has become clear. The British equity market has reacted with panic, fear, and forced selling, resulting in vertiginous falls and a new low on October 27 when the FTSE 100 closed at 3852.
It is a mark of the severity of the crisis that at this point the government stepped in. Hugh Duff, senior investment manager, UK equities for the Scottish Investment Trust, says: “We have had significant stimulus packages already with the billions spent bailing out the banks and the aggressive 150 basis points interest rate cut. There is also more in the pipeline, with the fiscal measures expected in the pre-budget report.”
United efforts by governments around the world may ultimately be the route out of this crisis, but it is not going to happen overnight. In fact, managers believe things are soon going to get far worse.
Britain is heading into a deep and prolonged cyclical downturn. Charles Deptford, equity income manager at New Star, says: “This recession isn’t like any other in our lifetime. It’s not like 1991; it’s a lot worse. I’m worried people won’t respond to interest rate cuts because they may not be passed on, and if they are, people may prefer to save rather than spend. People were surprised by the third-quarter GDP, but I wasn’t, and I expect the figure for the fourth quarter to be absolutely horrific.”
Potter adds: “As a result of the economic crisis we will get higher unemployment, there will be a secondary effect on property and on the high street, and banks will have more losses through ordinary bad debts. I don’t see any let-up any time soon in bad news.”
The managers feel that the market as a whole has not grasped the seriousness of what is going on. Derek Mitchell, manager of the Royal London UK Special Situations Trust, says: “Analysts have been very slow to react with downgrades. Only now we’re seeing some realism coming into the market, with 30% or 40% downgrades for this year/next year.” Rathbones’ chief investment officer, Julian Chillingworth, agrees: “Forecasts for earnings are 20%-30% too high. In the first quarter of 2009 there will be continued surprises on the downside.”
The expectation that things will get worse is one reason why valuations do not look as attractive as they might. Potter says: “People may say the market is cheap on nine or 10 times earnings, but you can only say that if the earnings are being delivered, and there’s no confidence they will be.” Barber expects earnings to fall by a third or more. He says: “We looked at the last four recessions in the UK and earnings fell 25%-30%. This is worse than average because everyone is overleveraged – banks, consumers, governments – so they are deleveraging. Earnings will fall over 30% or 35% in the next 18-24 months.”
Managers are acting accordingly. Many have been defensive for months and are now retrenching still further. Barber says: “We were defensive but we’ve moved even more so. Nothing is truly defensive but we’re trying to find the relatively resilient companies and sectors.”
Deptford, who took over his fund in July, says: “I bought a lot of pharmaceuticals, from nothing to about 8 or 9% of the portfolio. I cut out exposure to banks and housebuilders. In September I bought a lot of general insurance companies. I have 8% in that sector, it’s my biggest overweighting. I tried to buy certainty of earnings and dividends. Everyone was doing the same sort of thing.”
Michael Clark, the manager of the Fidelity Income Plus fund, says: “I’ve been buying into sectors where they will continue to pay dividends and where earnings aren’t cyclical, so I have a lot of utilities, large telecoms, pharmaceuticals and large oil companies.”
It is hard to be truly defensive in this market. Potter says: “Six months ago property, commodities and the Middle East were seen as defensive places to park assets. That myth has been completely destroyed. No asset is unblemished.” Manooj Mistry, head of db x-trackers UK, says investors have been rushing to the pedestrian and reliable: “Over the last 6-12 months our most popular products have been money market exchange traded funds.”
Despite this gloomy outlook, managers are not packing into cash and going home; they say a market recovery may be only months away. Deptford says: “I would expect the market to be higher at the end of next year than it is now. Interest rates will be 1% at the end of next year, so few assets are offering a big return. People will be asking where they can get a big return, and equities will enter the frame.”
Clark is even more positive: “If you look back to the 1970s, 1974 was a huge crisis in the UK with the three-day week, yet the market hit the bottom. From there it never looked back, and went up at a 45 degree angle until the late 1980s. So although things look bleak now, it may be the time to buy. Nobody can tell where the bottom is, but we are close to it by historical benchmarking and analysis.”
Other managers are less optimistic. Deptford says: “People still want and expect a rally. Once that has gone and people feel that the only way is down, that’s the time to put money in. We’re not there quite yet.” Potter is still more gloomy: “I could see the stockmarket bottoming in 6-9 months, but by then it could get back to the low 3000s.”
Potter says that we will look back on this period as the eye of the storm. The initial hurricane affected everything in its wake, leaving no asset untouched. Between now and Christmas things are likely to be a little quieter, but we must not mistake this for recovery. The next few quarters will see the tail of the hurricane, and managers are bracing themselves and their portfolios ready for the onslaught.